“Show me the money” – or how the institutional
aspects of monetary policy implementation
render money supply endogenous
Juliusz Jabłecki*
Submitted: 20 October 2009. Accepted: 17 March 2010.
Abstract
The paper presents a historical account of the evolution of modern financial systems. It is argued that money supply had been exogenous for the most part of history, but the demise of gold standard and the development of central banking have rendered it endogenous. The analysis is supported by a review of the monetary policy implementation framework of the National Bank of Poland. Causality test results show that the degree of the banking system’s liquidity did not Granger-cause credit expansion in the decade 1998–2008.
Keywords: money, money endogeneity, money multiplier, monetary policy implementation JEL: E51, E42, N20
1. Introduction
The paper is an attempt to investigate the process of money supply in modern economies. The motivation to study the topic follows from the remark made by Charles Goodhart (2001) who expressed his concern that even though it is often claimed that economics is built around two key concepts, demand and supply, the supply of money is generally treated somewhat less attentively than the demand for money. Indeed, in the economic literature, the supply of money is usually viewed simplistically from the perspective of the IS-LM framework as a variable determined exogenously by the central bank, which through its open market operations determines the level of commercial banks’ reserves, and then via the money multiplier also mechanistically controls the broader monetary aggregates.1
The view propagated by monetary theoreticians, which sees the central bank as a body essentially exogenous to the economic system and possessing a fair deal of control over the supply of money, has recently been challenged by the central bankers themselves who express concern that economic theory disregards some of the crucial aspects of the modern institutional setup of monetary policy. For example, Charles Goodhart, both an economist and one-time member of the Bank of England’s Monetary Policy Committee stated (Goodhart 1994, p. 1424):
Virtually every monetary economist believes that the CB can control the monetary base… and, subject to errors in predicting the monetary multiplier, the broader monetary aggregates as well… Almost all those who have worked in a CB believe that this view is totally mistaken.
The central problem addressed below is whether, and in what circumstances, the multiplier model of the money-supply process, understood as an institutional setup where broad money is causally determined – with a fair deal of accuracy – by the monetary base, can be a good approximation of reality. Two hypotheses are put forward and considered.
First, it is claimed that though the exogenous money view, incorporated in the money multiplier model, constitutes a largely accurate description of the financial system until the first half of the twentieth century, modern institutional conditions, as well as the monetary policy framework currently in operation are much better described by the assumption of endogenous money. To investigate this hypothesis, the historical evolution of the Western financial system is considered from the perspective of the money supply process. A conceptual distinction of four stages of development is applied to demonstrate how particular institutional changes have influenced the transformation of the nature of the supply of money from exogenous to endogenous.
Secondly, the hypothesis is put forward that the money multiplier does not adequately explain the money supply process in the modern Polish economy. The hypothesis is verified with the use of an econometric model, which tests whether an increase in the supply of bills issued by the National Bank of Poland (used as a proxy for excess liquidity) automatically leads to the creation of broad money and credit. It is found that the degree of the banking system’s liquidity did not Granger-cause credit expansion in the decade1998–2008. The result obtained strengthens the argumentation that
1 For example, Kashyap and Stein say: (1997, p. 3): “When the central bank wants more money in the economy, it
provides the banks with more currency that can be used as reserves (say by trading reserves for other bank securities). Banks then lever up the reserves through lending and crediting the checking accounts of the borrowers who receive the funds.”
money supply is endogenous in Poland and provides a new ground for analyzing the challenges for monetary policy under the current credit crunch. Specifically, it is remarked that given the endogenous nature of the money supply process, greater weight should be placed on bank capital rather than bank liquidity understood as possession of base money.
The review of the literature on the issues presented below reveals that they have so far received a relatively narrow treatment. Chick (1986; 1993) and Niggle (1993) stand out as those who have analyzed the institutional determination of the historical change from exogenous to endogenous money. Tobin (1963) deserves mentioning for realizing very early the money-creating potential of commercial banks and for drawing some theoretical conclusions from that observation. Moore (1988; 1989) has contributed to the framework for an empirical analysis of the money supply process and has shown by means of Granger causality tests the endogeneity of broad money supply in the UK. Goodhart (1987; 1994, 1989, 2001), Bindseil (2004) and Meulendyke (1993) have offered descriptions of the endogenous money-supply process from the perspective of central bankers. Finally, Howells and Bain (2005) have managed to incorporate the main points of the endogenous view on the money-supply process into a macroeconomics textbook. To the best of the author’s knowledge, Kot and Rozkrut (2004) and Borowski, Kot, Rozkrut and Szpunar (2005) are the only attempts (the latter unpublished) to argue that the money supply in Poland is endogenous. This project extends the previous treatment by offering an empirical analysis of money endogeneity as well as a detailed description of the model for monetary policy implementation in Poland.
2. Money exo- and endogeneity in the evolution of financial institutions and
monetary policy implementation
Before we move on, it is necessary to explain the precise meaning of exo- and endogenous money. Yeager (1997, p. 131) explains that the money supply is exogenous “if its nominal size is or can be controlled by the monetary authorities and does not automatically change as people make payments or try to build up or run down their money holdings.” Hence, exogeneity of the money supply means simply that it can be determined at the discretion of the central bank, independently of the financial system.2 By contrast, endogeneity implies that the supply of money is determined within the financial system by the demand for bank lending (Howells 2001, p. 134). The very root of the divergence between the two theories of the money supply process seems to lie in a different perception of the central bank and its role as the supplier of liquidity. Proponents of the exogenous view – implicitly or explicitly – ascribe to the monetary authority the ability to control the money supply, while adherents to the endogenous view hold that central bank does not and, in fact, cannot control the money supply. In the former view a central bank supplies the banking system with liquidity (in the form of reserves in excess of the mandatory minimum) which then works its way through the rest of the system roughly in accordance with the so-called money multiplier
2 A similar definition is given by Goodhart (2001): “An exogenous variable is one which is not set in response to other
current, or past, developments in the economy, e.g. it is fixed at some level irrespective of other developments, or is varied randomly according to the throw of dice, or the occurrence of sunspots, or whatever.”
mechanism.3 In the latter view, which might also be called bank-centric, it is the expansion of credit by commercial banks that ignites the money supply process, with the central bank stabilizing the interest rate and supplying the monetary base on demand of the banking sector.
In what follows we shall take heed of Hicks (1967, p. 153) who advised that “monetary theory… cannot avoid a relation to reality. It belongs to monetary history in a way that economic theory does not always belong to economic history.” Accordingly, this section reviews the evolution of monetary and financial institutions of the Western world and argues that the assumption of exogenous money and the multiplier model of the money-supply process constitute a largely accurate description of the financial system up to the first half of the twentieth century. However, modern institutional conditions, as well as the monetary policy framework in operation, are much better understood from the perspective of endogenous money view in the vein of the bank-centric model of money supply process.
Of course, it is next to impossible to divide Western (i.e. European and American) financial history of the last ten centuries or so into sequences following one another both logically and chronologically, not least because the specificities and timing of the process varied from country to country and because some changes were of quantitative rather than strictly qualitative character. Moreover, even though financial institutions can be fairly easily divided into strict analytical categories, it is much harder, perhaps even impossible, to map those categories onto historical evidence. Nevertheless, it seems that using a little abstraction – as does e.g. Chick (1986; 1993) and Niggle (1993) – it is possible to pinpoint several most significant stages of money and banking development, marking gradual enhancements in the ability of the banking system to create credit. Although Chick (1993) distinguished six such stages of development, it is sufficient for our present purpose to turn the attention to only four of them: stage one during which organized financial activity in its most primitive form develops; stage two, in which the principle of negotiability is recognized; stage three, in which an interbank market along with a central bank are established; and finally, stage four, in which the gold standard is abolished and the central bank becomes effectively the lender of last resort.
2.1. Stage one – the beginnings of banking
Stage one of banking development lasted from the beginnings of organized financial activity to sometime around the seventeenth century, though the timing of its finish varied (in Venice, for
3 The money multiplier approach to the supply of money was originally proposed by Phillips (1920) and subsequently
developed by other authors in the 1920s and 1930s. Since then, it has become a major pedagogical tool in mon-etary economics, dominating not only textbooks but appearing also in scholarly publications (for textbooks see most notably Mishkin (2004, pp. 375–381) and Mankiw (2007, pp. 514–515); for scholarly publications see e.g. Brunner (1961), Brunner and Meltzer (1964)). The multiplier itself is simply defined as the ratio of the total money supply (M) to the monetary base (B) which consists of cash in circulation (C) and commercial banks’ reserves in the central bank (R). Let b denote the portion of the money supply which people prefer to hold in cash, so that bM = C, and let r be the reserve requirement ratio held against deposits D, so that R = rD. By simple manipulations we obtain:
m=CM+R=bMM+rD=bM+r(MM−C) =bM+r(MM−bM)=b+r1(1−b) (*) 1 0 ∑ − = −+ + + = j t j t n i ∑=1 n i i t i t DC DL DC α α β ε ∫ ∫ − + − − = + = = ∀ ) | ( ) | ( ( ) [ | ] (1 ( ) ) ] | [ ) ( ] | [ ) ( ] | [ , ..., 1 dx x f I i E dx x f I i E long P I i E short P I i E i T: t I OMO A I OMO A −∞ ∞ − 0 0 t t − | ) ( fAOMOIt t D t B t D t B t ) ( x
From the perspective of the multiplier model it makes perfect sense to argue that the money supply is in fact exogenous, for it is the changes in the monetary base as well as in the reserve-deposit ratio, both of which are assumed to be controllable directly by the central bank, that cause changes in the broader monetary aggregates.
example, checks were generally not permitted even as late as in the eighteenth century). The somewhat vague term “beginnings of banking” corresponds in Europe roughly to the twelfth century, as historical evidence from Genoa (Hall 1935), Bruges (de Rover 1942; 1974) and Barcelona (Usher 1934; 1943) suggests that already at that time a variety of what would be called today banking activities were carried out professionally and concurrently on a noticeable scale, yet with different legal status. About the same time when, as Usher (1934) reminds us, Henry II of England deposited funds for safekeeping with the Templars (at least twice: in 1282 and 1286, as – ironically enough – did his adversary Philip II Augustus), lombards (pawnbrokers) and money-changers operated in Bruges (de Rover 1942, pp. 64–65). The former would offer typical loan services, which involved only a transfer of purchasing power, whereas the latter developed a system of local payments by book transfer with the concept of overdraft.
A similar pattern of specialization is found by Hall (1935, pp. 75–76) who argues that although according to Genoese notarial records from the late twelfth and early thirteenth centuries instances of typical borrowing and lending were still somewhat sporadic at the time (for example, between 1179 and 1186 only three loans were extended in the city of Genoa), many merchants did already have bank accounts which they used to make payments by transfer during trading fairs, such as those held in the Champagne region of France. Importantly, the accounts served not only as a clearance system but also as a vehicle of credit, as they were oftentimes allowed to be overdrawn and settled only at the next fair. Bankers, of course, were desirous of making profit with the money entrusted to them and invested their resources directly in business ventures without depriving depositors of their right to claim the deposits any time they may have seen fit. Hall (1935, p. 77) recounts two interesting examples from the Genoese notarial records:
In 1186, Rubeus Bancherius acknowledged that he had £7 belonging to Andreas, a servant of one of the members of the great Fieschi family. He promised to pay the capital fifteen days after demand; and, he said, “if God should give any profit on those pounds, I will give you as much of it as seems best to me.”… [In 1186] Bernardus Bancherius acknowledged that he had received from one Maria Sarda £11, which he was holding in his bank. He promised to return the £11 eight days after demand and to pay her in addition 10 per cent a year on her capital as long as he held it.
It is hard to estimate exactly the level of reserves held against deposits of the earliest medieval banks but thanks to the ledgers of two money-changers, Collard de Merke and Guillaume Ruyelle, preserved in the municipal archives in Bruges and covering the period 1366–1371 (kept in single entry), we know that cash reserves could amount to about thirty percent of liabilities, part of which were demand accounts (de Merke had about two hundred regular clients). A similar picture emerges from the books of the fifteenth-century Bank of Deposit in Barcelona which held reserves in specie coming to about 29% of its liabilities. There is, then, little doubt that – as Usher (1943, p. 181) explains – the early medieval bank could extend credit of the volume significantly greater than the cash it held at hand via the multiplier model. The reason why it makes sense to refer to the multiplier mechanism as the driving force of credit expansion is that banks’ ability to extend credit is conditioned upon their prior possession of deposits/reserves. As Chick (1993,
p. 84) puts it: “bank lending… depends on exogenously-given deposits, which at this stage are a form of saving.”
It should be stressed that though the process of credit expansion was evidently possible, its extent, from the perspective of an early medieval bank, was significantly limited. First of all, banking constituted only a very small segment of the medieval economy and concentrated almost exclusively in large urban areas. Munro (1994, p. 152) reports, for example, that even in Venice and Bruges only about 10% of adult males had bank accounts. Second, banking contracts were, at the time, almost exclusively oral due to the much restricted knowledge of writing and reading and, consequently, should anyone want to settle their payments by a book transfer, they would have to take the recipient of funds to the bank and request that a specific amount of money be transferred from one account to the other.4 Third, a loan extended by one bank was unlikely to return to that bank as a deposit, and since the vast majority of transactions required metal coin (Spufford 1986), it might even leave the system altogether. Fourth, even though simple credit instruments already existed, such as e.g. bills of exchange (instruments sold for ready cash, which were exchangeable into foreign currency at some later point abroad6), there were at the time no legal provisions ensuring protection for the holders of such loan contracts, which effectively restricted their use to a small community of merchants, and, incidentally, led to their effective ban by the Hanseatic League in 1370 on account of their fraudulent nature. Last but certainly not least, there was the possibility of a bank run:
A bank run occurs when the clients of a bank – its depositors or noteholders – lose confidence in their bank, and begin to fear that the bank does not really have the ability to redeem their money on demand. Then, depositors and noteholders begin to rush to their bank to cash in their receipts, other clients find out about it, the run intensifies and, of course, since a fractional reserve bank is indeed inherently bankrupt – a run will close a bank’s door quickly and efficiently (Rothbard 1986, p. 113).
Runs were all the more probable due to a still relatively minor size of the early medieval banks which corresponded to the relatively small size of the communities they served (in the early fourteenth century Venice was the only commercial center with population above 100,000) and undeveloped accounting methods. Kohn (1999a) reports, for example, that in mid-fourteenth century Bruges, the typical bank had fewer than 100 depositors, a dozen major of whom accounted for as much as two-thirds of deposits. Thus, it was relatively easy to coordinate a run – a sudden withdrawal of cash – which would leave the bank broke.
Even though from a historical point of view there is scarcely any basis for assessing the quantitative importance of credit in the first stage of banking development, it is probably safe to say that the net credit creation was rather negligible. Thus, while it does seem that from very early
4 Interestingly, this method was resorted to even if only one party to the transaction had a bank account. See Usher
(1943, pp. 184-185), de Roover (1942).
In the early Middle Ages gold and silver coins were the predominant media of exchange, though Usher (1943, p.12)
argues that at times coins – produced by mints invariably subordinated to the local authorities – were so badly clipped that merchants actually considered bank accounts as more reliable, since bankers, unlike monarchs, were severely punished if they failed to meet all the claims of their depositors.
on lending exceeded banks’ holdings of high-powered money, it was nonetheless limited by the flow of new deposits and the existing depositors’ willingness to hold money substitutes rather than money proper. The latter in turn was related to the acceptability of deposits as means of payment which brings us to the second stage of banking development.
2.2. Stage two – the principle of negotiability
Stage two brings one qualitative difference which, in turn, signals important quantitative changes. Around the sixteenth century the principle of negotiability became gradually recognized, which led to further development of clearance and fostered banks’ integration into a more coherent system. As argued above, possibly the most significant impediment to the expansion of credit in the Middle Ages was that debt instruments (e.g. letters obligatory or checks) were not generally acceptable as means of payment, as the law gave little legal and financial protection to their accepters.
Medieval law recognized the difference between assignable and transferable claims. An instrument is said to be assignable, if B who received a letter obligatory acknowledging A’s liability can, before maturity, assign the right to collect the debt to a third party, C, without giving notice to A (see e.g. Kohn 1999). If additionally C retained the full rights of B vis-à-vis A, then the instrument would be transferable. Thus, writes Kohn (1999, p. 24):
Unlike an instrument expressing a debt to a specific person, a transferable instrument is impersonal: it is evidence of the debt on the part of the issuer to anyone who acquires the instrument. In this way, it is like currency.
According to Munro (1994, p. 174), England was the first to introduce the new regulations on transferability when law-merchant Mayor’s Court famously ruled that the “bearer presenting a bill for collection on its maturity had as much right to the payment as the original payee in the bill.” The problem was that while some small merchant communities recognized full transferability of letters obligatory it was not so with civil courts. Van der Wee (1977) provides an interesting account of how with the expansion of trade centers in Bruges and Antwerp newcomers would often issue debt instruments as a form of payment but then avoided responsibility and refused payments to third parties seeking refuge in civil courts:
In the budding new trading centers in the North… prosecutions were legion; the merchants’ circle was not as close or intimate as in the traditional centers of the South; unknown, unreliable newcomers kept on turning up. (p. 325)
Soon however, civil courts in major centers of commerce recognized the transferability of debt instruments: Lübeck in 1502, Antwerp in 1507, and – with the Habsburg edicts of 1537 and 1541 – the whole of Netherlands.
We should stress again that what this recognition meant in practice was that checks, bills of exchange, and promissory notes could become par excellence generalized media of payment and the whole procedure of interbank transfer could be greatly simplified. More importantly perhaps,
to the extant that banks started holding accounts with one another, it were no longer cash reserves of the individual bank but total reserves of the slowly emerging banking system that limited credit expansion, since in times of distress less prudent banks could, in principle, borrow reserves from the more prudent ones. Documents from sixteenth-century Venice, for example, reveal it was not uncommon that when a person came to demand his money, the bankers would take him to another bank and transfer credit to him only at that other bank. The broad significance of the practice of banks making use of each other’s notes was fully appreciated by Usher (1943, p. 25):
When notes are used in this fashion, the credit of one bank becomes in fact part of the effective “reserve” of the issuing bank. Functionally, this use of credit does not differ from the use of deposit credit in another bank as means of payment. In practice, however, such a use of bank notes increased considerably the total lending power of the group or system of banks. The specie basis needed to support credit structure was significantly diminished. Thus, we see that stage two – with the changes it brings about – really does considerably extend the total lending power of the financial system. Nevertheless, for reasons astutely described by Rothbard (1986, pp. 111–124), there were still significant limitations to credit expansion. The centralizing trends notwithstanding, banks had little interest in indefinitely holding on to checks issued by their competitors and “adding them to their reserves.” After all, keeping other banks’ liabilities was equivalent to allowing the money to lay idle, for even if such interbank deposits brought interest, more could be earned by calling for redemption and lending the money out. This means, however, that if a bank started to expand credit, and consequently, its clients through increased volume of purchases started to raise prices all around (using bank liabilities as means of payment), then rival banks would most likely call for redemption of its demand liabilities, which in turn would drain its reserves and enforce a curtailment of lending.7 In fact, as Schuler (1992, p. 81) documents, this was not merely a theoretical possibility but an aggressive competitive strategy called “note picking” or “note duelling”, whereby banks would first willingly accept and accumulate large quantities of notes issued by rival banks and then simultaneously present them for redemption hoping to force the unprepared bank to suspend payments and go into liquidation. Munn (1981, pp. 23–24, 141) finds evidence that the fear of raids conducted by rival banks forced one of the Scottish provincial banking companies in the late 18th century to hold reserves of up to 61.2% of its liabilities.
Given, then, that any individual bank had no guarantee that the secondary deposits it created would remain with it or even with the banking system as a whole, its willingness to lend beyond the cash it held on hand was determined by its forecast liquidity position. Specifically, credit expansion depended on the prospect of new reserves, either from an entirely new deposit of gold
7 This argument follows the lines of the famous “specie flow price mechanism” developed originally by Richard
Can-tillon in his Essai sur la nature du commerce en general in 1730 and later ironed out by Hume and Ricardo. Writes Rothbard (1995, pp. 358–359): “No one was more lucid about the problem of money and international payments than Cantillon. He pointed out that specie can either be acquired within a country by mining ore, or … a favorable balance of trade with other countries. But then, in the Cantillon process analysis, either the mine owners or the exporters would spend or lend the money. Part of the expenditure of the new money would surely be spend abroad, and furthermore the increased stock of money would raise prices at home, making domestic goods less competitive. Exports would fall and imports of cheaper foreign products would increase, and gold would flow out of the country, reversing the favorable balance of trade.”
or silver or from capital inflows, as well as on what we have termed in Section 1 the leakage coefficient, the estimate of which depends on the micro level on the individuals’ preference for cash and on the macro level on the degree of integration of the banking system.
The crucial aspect of the institutional arrangements characteristic of stage two of banking development is still the exogenous nature of money and a multiplier-like process of its supply. According to Chick (1993, p. 81):
In the second stage, claims on deposits are widely used as a means of payment. This is, historically a new role for deposits, with a far-reaching implication. Holdings of bank liabilities now represent money used to support consumption as well as representing saving. Mainly for that reason, the redeposit ratio from bank lending will be high. Reserves, rather than the acquisition of savings, become the constraint on lending. Given an addition to reserves whether from a deposit new to the banking system [or]… capital inflows, banks taken as a whole can lend out a multiple of this amount, creating secondary deposits as they do so. This is t he stage to which t he deposit multiplier begins to apply [emphasis added].
2.3. Stage three – interbank market and central banks
We have argued above that one important determinant of an individual bank’s willingness and ability to extend credit was the degree of integration of the banking system. Thus, the novelty of stage three, which – though analytically distinguishable – historically coincided at least partly with the emergence of stage two, is the rise of interbank lending and the forging of banks into a coherent system. What this means in practice is that instead of fighting one another by “note picking”, banks started to generally accept one another’s notes and checks at par. Nonaggression seems to have followed as a result of banks’ recognition that the tit-for-tat competition, which consisted in insisting on note-redemption by other banks and replenishment of own reserves when rivals retaliated, was more costly in the long run than cooperation. The resulting build-up of trust and confidence among banks allowed also the development of interbank lending thanks to which reserve deficits of some banks did not necessarily have to lead to bankruptcy, but could be offset by reserve surpluses of other banks.
Naturally, this process of mutual note acceptance improves the market for any bank’s notes and, if unintentionally, for the notes of its competitors. The result is a marked increase in note circulation and a gradual displacement of commodity money by bank-issued money. However, according to Selgin and White (1985, p. 14):
A large part of specie formerly used in circulation to settle exchanges outside the banks may still be needed to settle clearings among them. The banks can substantially reduce their prudentially required holdings of commodity money by participating in regular note exchanges which allow them opportunities to offset their mutual obligations. Only net clearings rather than gross clearings are then settled in commodity money. The probability of any given-sized reserve loss in any given period is accordingly reduced (by the law of large numbers) and each bank can prudently reduce its ratio of reserves to demand liabilities.
Thus, even though the final total of credit creation is evidently still dependent on the amount of reserves available to the banking system, the multiplier process, initiated in stage two, becomes in the current stage more rapid and there remains less excess liquidity in the system (Chick 1993, p. 82).
Banks soon learn also that the gains from bilateral note exchange described above could be greatly enhanced by implementing a system of multilateral note exchange. To give just a rough idea of the possible scale of such gains consider the following simplistic example.8 Suppose there are only three banks A, B, and C, and that A has collected GBP 20,000 of B’s notes, B has GBP 20,000 of C’s notes and C has GBP 10,000 of A’s notes. If the banks were to settle the exchanges bilaterally, then depending on the chronological order of the exchanges, they would need between GBP 20,000 and GBP 40,000 worth of gold reserves. If, however, balances are settled multilaterally, then the amount of gold reserves needed drops to only GBP 10,000, since A’s net balance to B and C is GBP 10,000, B’s net balance to A and C is GBP 0, and C’s net balance to A and B is minus GBP 10,000 – hence all the dues may be settled by a transfer of GBP 10,000 worth of gold from C to A.9 In practice, the advantages derived from multilateral note exchange were even more pronounced, for if banks could agree on settling their debts in one place and at a given time, they saved not only reserves, but also time and transportation costs. Thus, the institution of clearing houses came into being, the original purpose of which was to serve as a convenient debt-settlement place. Bisschop (2001 [1896]) offers an account of the formation of the clearing house in London which seems worth quoting at length:
Whilst therefore the banks followed a system of compensation whenever possible, the clerks on their part, being obliged to run backwards and forwards to the various offices, gradually saved each other the trouble of demanding payment at the offices of the respective bankers. The majority of them belonged to offices which were situated in Lombard Street, which caused the clerks to meet each other frequently. This led to interchange of information regarding the mutual demands on each others’ houses, and the subsequent exchange of the documents which represented the respective demands. Soon these occasional encounters developed into daily meetings at a certain fixed place in order to save each other as much inconvenience as possible. At length the bankers themselves resolved to organise these meetings on a regular footing in a room specially reserved for this purpose.
While initially an outgrowth of chiefly practical concerns, the clearinghouses soon became also the media of unification and coordination of the individual banks’ actions facilitating the process of credit supply and protecting the banks from fraud and forgeries. For example clearing houses started to serve as primitive credit information bureaus, since to the extent that they operated by pooling and investigating the records of the member banks, they could also readily check credit histories of particular debtors, their debt-exposition to respective banks in the system and the like. More importantly perhaps, clearinghouses took up the role of policing the soundness of member banks’ balance sheets to assure that the notes presented for clearance did not involve undue risk. Thus write Selgin and White (1994, p. 1732):
8 The example is borrowed from Selgin and White (1985).
9 De Soto (2006, p. 467) attests to this: “Furthermore, bank consolidation makes it possible to better manage fractional
[Historical] experiences suggest that member banks of a laissez faire clearing system would jointly agree to conform to clearinghouse liquidity and solvency standards, and to allow their enforcement via audits, because each bank wants credible assurance that notes and deposits issued by the other members (which it is accepting at par) will be redeemed in full.
Clearinghouses, with their organizational framework and outreach, were oftentimes also the bases of cartel-like arrangements regarding the interest and exchange rates or fees charged by the member banks.10 However, their most important role stemmed from the capacity to help the members meet their contractual obligations in times of stress. If a bank was temporarily unable to pay its clearing balances, or if it faced a sudden run on its gold reserves, the clearinghouse was a medium through which more liquid banks could lend to the less liquid ones for the sake of preserving the stability of the whole arrangement. The clearinghouse’s role was crucial since it authorized the issue of special loan certificates by the failing bank, judged the quality of assets submitted by the latter as collateral, and specified the haircut, or discount rate, to be applied to the collateral. The loan certificates, which had a fixed maturity of typically one to three months, circulated among the creditor banks and could be used by them later on in the clearing process.11
What should be obvious by now is that clearinghouses had many characteristics of modern central banks: besides their obvious role as centers of clearance, they admitted, expelled, and fined members; they imposed price ceilings, audited the members and reviewed their balance sheet reports; last but certainly not least, they provided insurance during panics. By pooling reserves and issuing loan certificates clearinghouses were well-prepared to stave off asymmetric reserve shocks, i.e. sudden drains of cash (stemming e.g. from an increased demand for cash) hitting one bank or a minor group of banks, however they were in principle unable to deal with a symmetric reserve shock – i.e. a general rise in the demand for cash, directed simultaneously at all member banks. As Smith (1990 [1936], XI.34) notes, bankers soon became well aware of that:
Both the successes and the failures of the clearing-house loan certificate device gave force to the conclusion, firstly, that there should be somewhere an adequate reserve of lending power for use in the crisis, and, secondly, that this should be available for the collective benefit of all banks. Further, the idea was gaining ground that it could only be provided by an organisation in some manner aloof from the operations of ordinary commercial banks. It must be a bank that was in normal times not fully “lent up.”
Little wonder, then, that as Gorton (1985, p. 283) notes, the Federal Reserve System, the American central bank set up in 1913, was simply the nationalization of the private clearinghouse system.
The centralization of clearance under the auspices of the government meant unquestionable favors and usually entailed also granting to the most influential, or the biggest, bank the monopoly
10 Thus, “…entry to the clearinghouse was screened, and then members were regulated. There were capital
requirements, reserve requirements, interest rate restrictions, and ongoing audits and reporting forms to ensure compliance” (Gorton 1985, p. 279).
of note issue.12 Under such an arrangement, smaller banks would deposit their reserves with the stronger central bank (privately owned but state-chartered), which in turn would issue notes redeemable in gold (sometimes deposits were interest-bearing) and offer liquidity assistance to the others in time of asymmetric reserve shocks. Most importantly, however, government protection solved also the problem of symmetric reserve shocks: should the banking system as a whole face a run on its gold reserves, the government could declare central bank notes to be the legal tender and temporarily suspend their convertibility into gold.13 Admittedly, such remedy was still perceived as a short-term one at the time, but it seemed to have worked fairly well. In return for the privileges granted to them, the newly founded central banks were expected to relieve the government from its financing problems by subscribing their capital to the purchase of sovereign bonds.14
The creation of a central bank pushes the limits of credit expansion even further, since – by imposing enforceable reserve requirements – it encourages banks to expand credit at the same pace and it institutionalizes the lender of last resort facility. Importantly, it is at this time that the term “central bank money”, referring to banks’ reserves held with the central bank, gains significance, as it is central bank notes and deposits that begin to serve as the vehicle of clearance centralized under the auspices of the central bank. Though the transformation of money into central bank liability might seem to put the latter in the position to control the economy’s general credit situation, central bank’s actual power to influence the national money supply was rather limited and constrained by the obligation to keep its notes and deposits redeemable.15 As Goodhart (1995, p. 249) notes:
The Central Bank under a specie standard aims to maintain convertibility of local money into specie according to the “rules of the game.” These were simple: the Central Bank should raise interest rates, when the proportion of the metallic reserve to its own notes
12 Indeed, writes Smith (1990 [1936], XII.4):
“The guardianship of the bulk of the gold reserves of the banking system is obviously an accompaniment of the monopoly in the note issue: the holding of a large proportion of the bankers’ cash reserves is also bound up with the same factor – it is a matter of convenience for the banks to keep their surplus balances at the central bank but it is safe for them to entrust a major part of their cash reserves to a single outside establishment only if they can be absolutely certain that this authority will be able in all circumstances to pay out such reserves in a medium which will be always acceptable to the public. This can only be guaranteed if the notes of this authority can be given forced currency in time of need”.
13 Laidler (2004) provides an interesting case in point: “In 1797, the war was not going well for the opponents of
Revolutionary France, and in February of that year a small French force landed on the coast of Wales. Though this event was of nomilitary significance, since the force in question was soon rounded up, it precipitated a run on the British banking system that was only halted by the suspension of the Bank of England’s obligation to convert its notes on demand into gold bullion. This “temporary” suspension was to remain in place until 1821…”
14 On this aspect of the bargain see in particular Goodhart (1987).
15 One channel of the equilibrating mechanism was the specie-flow mechanism referred to earlier and nicely elucidated
by Bagehot (1873, pp. 58–59):
“If a bank with a monopoly of note issue suddenly lends (suppose) 2,000,000£ more than usual, it causes a proportionate increase of trade and increase of prices. The persons to whom that 2,000,000£ was lent, did not borrow it to lock it up; they borrow it, in the language of the market, to “operate with” that is, they try to buy with it; and that new attempt to buy that new demand raises prices… A rise of prices, confined to one country, tends to increase imports, because other countries can obtain more for their goods if they send them there, and it discourages exports, because a merchant who would have gained a profit before the rise by buying here to sell again will not gain so much, if any, profit after that rise. By this augmentation of imports the indebtedness of this country is augmented, and by this diminution of exports the proportion of that indebtedness which is paid in the usual way is decreased also. In consequence, there is a larger balance to be paid in bullion; the store in the bank or banks keeping the reserve is diminished, and the rate of interest must be raised by them to stay the efflux.”
and deposits was falling, and vice versa… t he Cent ral Ba n k, under such a metallic sta nda rd, ca nnot create gold (or silver), but it ca n att ract reser ves by using its open ma rket operations to adjust relative interest rates [emphasis added]. Hence, all the important institutional changes notwithstanding, the central bank was still held in check by the country’s commitment to gold standard. And even though it may seem that money slowly becomes endogenous at this stage, thanks to the lender of last resort facility available on the discretion of banks in need, it is in fact still exogenous – determined by the total supply of gold in the system. As a matter of fact, under such circumstances – i.e. as long as the country remains politically committed to preserving the gold standard – the central bank’s lender of last resort function cannot be exercised in a credible way. For example, Wigmore (1987) argues that the Fed’s failure to protect the banking system between 1932 and 1933 stemmed from its fear – admittedly not irrational – that significant lender-of-last-resort borrowing by failing banks (via the discount window) would undermine the dollar’s link to gold. Sachs (1998) and Caprio et al. (1996) make a more general point that a credible lender of last resort is incompatible with currency boards, i.e. regimes where the domestic notes and coins in circulation are fully backed by foreign currency reserves and are convertible into a foreign “reserve” currency on demand at a fixed rate (see e.g. Hanke and Schuler, 1991) – a point explicitly recognized in the formal definition of a currency board regime adopted by the IMF.16 Consequently, under such conditions the stock of money is determined essentially outside the banking system.
2.4. Stage four – demise of gold standard and modern central banking
We have seen how in the course of the three stages outlined above, banking developed by progressively reducing the amount of reserves held against liabilities and by relaxing the constraints on credit expansion (Usher 1943, pp. 183–184). This process ends, both logically and historically, with the creation of a central bank equipped with the function of the lender of last resort for the inherently unstable fractional reserve system (Bagehot 1873, p. 58). We have argued that, though the reality and the institutions of the money-supply process changed drastically over the three stages, money remained largely exogenous for the whole time – i.e. its stock was effectively constrained by the amount of specie for which deposits, notes and checks were only substitutes. The nominal supply of money did not vary with people’s preferences – a precondition of endogeneity as described by Yeager (1997, p. 131). To the contrary, it was inextricably tied to the stock of gold in the economy and increased multiplier-like only via the original increase of gold reserves in the banking system. This setup changed only quantitatively after the creation of the
16 IMF defines a currency board as: “A monetary regime based on an explicit legislative commitment to exchange
domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. This implies that domestic currency will be issued only against foreign exchange and that it remains fully backed by foreign assets, leaving little scope for discretionary monetary policy and eliminating traditional central bank functions, such as monetary control and lender-of-last-resort [emphasis added].” Such an arrangement should not be confused with a currency peg. A country’s commitment to fix the exchange rate, i.e. to maintain a specific price of foreign currency in terms of domestic currency, may be compatible with providing last resort assistance to its banks, and consequently with the money supply being endogenous.
central bank (reserves could then be used much more efficiently) since the latter, too, was limited by the existence of the international gold standard and, according to Bagehot (1873, p. 155), its “first duty… was to protect the ultimate cash of the country and to raise the rate of interest so as to protect it”.17
Stage four indicates the birth of modern reserve banking and begins with severing the link between national currencies and gold which, in most countries happened with the outbreak of World War I.18 Unconstrained by the specie flow mechanism inherent in the gold standard, central banks emerge now as sovereign players in the interbank market and their modus operandi becomes the key to understanding the nature of the supply of money. Smith (1990 [1936], XII.42) observes that:
The policy of the central bank is no longer conceived to be automatic in the manner envisaged by the founders of the currency school. The volume of circulating media does not change in response to specie movements. These may be ignored or offset as the central bank management thinks fit. With the aid of discount rate and open market operations it adopts an active policy of increasing or decreasing the cash reserves of the money market and the total volume of credit.
Smith correctly perceives the enormous extension of monetary power facilitated by the demise of the gold standard, but she seems to somewhat hastily infer that just because central banks become unconstrained in their reserve management, they must also manipulate the supply of money at will. As a matter of fact, such a state of affairs would not be fundamentally different from the one prevailing in the era of metallic money – the only distinction being that before the overall stock of money was fairly rigidly set by the supply of gold and now it is fairly rigidly set by the discretion of monetary authorities. This, however, seems to be an inaccurate simplification which overlooks the reason why central banks were established in the first place: “for the purpose … of increasing the liquidity of member banks by providing for the rediscount of their eligible paper” (report of the Federal Reserve System on Bank Reserves presented in 1931, quoted in Goodfriend, Hargaves 1983, p. 37). Recall, that under a fractional reserve system banks are exposed to the so-called maturity mismatch: they borrow short and lend long, which essentially translates into offering long-term loans and financing them with demand deposits (Heffernan 2005, pp. 105-106). This renders the money market inherently unstable since both the supply of cash reserves, i.e. the available stock of specie, and the short-term interest rate is volatile and inelastic. As Bagehot (1873, p. 58) goes on to explain:
But though the value of money is not settled in an exceptional way, there is nevertheless a peculiarity about it, as there is about many articles. It is a commodity subject to
17 See also Goodhart (1995, p. 249).
18 Admittedly, the transition from metallic money, characteristic of the ancien régime, to purely fiat currencies, typical
for stage-four banking systems, involved the passage through various sub-stages (domestic convertibility, suspended during World War I, international convertibility, i.e. the gold-exchange standard when only large international payments could be settled in gold – this scheme operated briefly in the 1920s – and the so-called Bretton Woods system which was essentially a watered down version of the gold-exchange standard operative from 1945 to 1971), yet each of those sub-stages moved the banking system further away from an exogenously driven money supply, and thus is omitted here for the sake of brevity. A detailed treatment of the demise of the gold standard see Rothbard (2005).
g reat f luctuations of value, a nd t hose f luctuations a re easily produced by a slight excess or a slight deficiency of qua ntity. Up to a certain point money is a necessity. If a merchant has acceptances to meet to-morrow, money he must and will find today at some price or other. And it is this urgent need of the whole body of merchants which runs up the value of money so wildly and to such a height in a great panic. On the other hand, money easily becomes a “drug,” as the phrase is, and there is soon too much of it [emphasis added].
The conditions related by Bagehot implied that the money market was plagued by extreme movements of short-term interest rates. Indeed, according to the findings of the U.S. Senate Banking and Currency Committee, which prepared a report in November 1913 on the money market conditions prior to the establishment of the Federal Reserve System, during the single year 1907 interest rates varied from 2 to 45% in January, from 3 to 25% in March, from 5 to 125% in October, from 3 to 75% in November, and from 2 to 25% in December (quoted in Burgess, 1946, pp. 278–279). With the development of financial instruments, and in particular of convertibility of time deposits into demand deposits and demand deposits into cash, the transitory supply shocks to bank’s balances with the central bank have been possibly even aggravated. The problem with thus produced fluctuations of short-term interest rates is that they tend to be transmitted to longer-term rates and eventually translate into movements of the whole yield curve.19 While short-term rates have, by themselves, little economic importance, medium– and long-term rates – influenced by short-term rates – determine the economy’s saving/investment patterns, i.e. underlie such crucial decisions as: how much to save, how much to invest, how much to consume. Erratic behavior of those rates introduces noise into economic agents’ decision-making and pushes it away from the equilibrium. So developed the argument that the central bank should neutralize such transitory shocks and use its discount rate (i.e. the rate at which it discounted bills) as an operational target, the proper choice of which could provide a sound economic environment:
A bank rate that is thus regulated [so as to ensure price stability – J.J.] comes as near to the equilibrium rate of interest as it is practically possible to ascertain. With such a bank rate… the whole economic life is approximately regulated as if the bank rate were at every moment kept exactly equal to the theoretical equilibrium rate of interest. By applying this practical rule, therefore, we secure the highest possible stability both for the general process of price-fixing and for the whole economic life. In fact, we eliminate as far as possible all the disturbances arising out of deviations of the actual rate of interest from the equilibrium rate… any deviation of the actual rate of interest from the true equilibrium rate may be the cause of very serious and very widespread disturbances (Cassel 1928, pp. 518–519).
19 The expectations theory of the term structure of interest rates states that the interest rate on a long-term bond equals
an average (e.g. an arithmetic or geometric mean) of short-term interest rates that investors expect to occur over the life of the long-term bond. See e.g. Mishkin (2004, pp. 129–132).
Thus, central banks gradually began concentrating – initially only in practice, not necessarily in the way they communicated their monetary policy implementation – on short-term interest rates as variables they wished to control on a daily basis.20
Central banks have conventionally three main tools, or instruments, at their disposal to reach the operational target: (1) open market operations, i.e. conditional or outright purchases and sales of securities at the interbank market undertaken at the initiative of the central bank itself; (2) standing facilities, which have the same economic effect of liquidity provision (or in the case of deposit facility – subtraction) as open market operations but are undertaken at the initiative of the commercial banks; and (3) reserve requirements, i.e. ratios of deposits that must be held as vault cash or balances with the central bank (known to banks in advance and typically binding, possibly on average, over some specified maintenance period). Bindesil (2004, pp. 77-102) presents a detailed model of central bank control of short-term interest rates. We need not bother here about the specifics of his exposition, but just to get an idea of how central banks go about their business, let us inspect a typical central bank balance sheet, as it is the most concise source of information of the latter’s activities (Table 1).
Table 1
An ideal central bank balance sheet
Assets Liabilities
Autonomous factors
Gold and foreign currency Investment and other assets Capital and reserves
Banknotes in circulation Government deposits Other liabilities
Monetary policy operations
Liquidity injecting standing facility Liquidity injecting open market operations
Liquidity absorbing standing facility Liquidity absorbing open market operations
Operational reserves Commercial banks’ balances(including required reserves) Source: Bindseil (2004, p. 48), rearranged.
20 Historically, largely under the influence of the multiplier model developed by Phillips (1931 [1920]) and the
academic contributions of the monetarist school, some central banks claimed to pursue a strategy of monetary targeting, i.e. strived to attain a particular growth rate of some measure of the money supply. The most notable example was the U.S. Fed led by Paul Volcker in the period 1979–1982 when attempts were made to practically define the central bank’s target in terms of a reserve quantity. However, Mishkin (2004, p. 425) argues that the Fed was never truly committed to attaining its targets (in fact, it successively failed to drive M1 into the target range) and used the monetary targeting rhetoric only to avoid responsibility for drastic interest rate hikes that were needed to bring down inflation. Goodhart (2001) goes even so far as to call the Fed’s approach “play-acting.” Later on, we shall return to the question of why it is in practice very difficult, not to say impossible, for monetary authorities to control the monetary base (as is required by the multiplier model).
The logic of central bank’s liquidity management can be understood as provision of liquidity through open market operations in a way that, after taking into account the effects of autonomous liquidity factors (e.g. changes in the amount of banknotes in circulation or changes in government’s deposits with the central bank), commercial banks can fulfill their reserve requirements on average over the maintenance period.21 For example, when the demand for notes and coins increases, as it does for example before Christmas or weekends – when people rush to ATMs to draw down their demand accounts – commercial banks’ reserves with the central bank decrease because their holding of cash is usually included in reserves (as “vault cash”) and because banks obtain cash by drawing down their balances with the central bank. By a similar token, government deposits usually rise causing a corresponding decline in the banking system’s deposits outstanding, which in turn renders the reserves insufficient, puts upward pressure on the interest rate, and requires an addition of liquidity either through open market operations or standing facilities. We shall trace this reasoning on a simplified example (borrowed and slightly modified from Foot et al., 1979).
Consider an economy characterized by the following properties:
a) banks maintain 4% of deposits taken from the public as vault cash to meet immediate operating needs and 1.5% of deposits as balances with the central bank;
b) the 5.5% specified in (a) constitutes the required reserve imposed by the monetary authorities on the banking system;
c) cash in circulation amounts to 15% of deposits; and
d) the central bank strives to control the short-term interest rate, i.e. the rate it charges commercial banks for liquidity.
The equilibrium of the economy is presented in Table 2.
21 Some central banks, e.g. Australia Canada and New Zealand, abstain from imposing reserve requirements on
commercial banks. This, however, as proved by their good track record and scholarly contributions such as e.g. Woodford (2003, does not significantly impair the ability to control short-term interest rates, since as long as banks inelastically demand clearing balances from the central bank (and the abolishment of reserve requirements does not change that), the latter is in the position to charge any price it thinks fit for them.
Table 2
The economy in initial equilibrium
Central bank Banking sector Non-bank private sector
assets liabilities assets liabilities assets liabilities
Banks’
balances 1.5 Balances with CB 1.5 Deposits 100.0
Vault cash 4.0 Vault cash 4.0 Equity in banks 10.0
Cash in
circulation 15.0 Other assets 104.5 Cash 15.0
Government
deposits 5.0 Deposits 100.0
Capital 10.0
Now suppose that in a given period the public sector is a net recipient of one unit from the non-bank private sector (a situation which might occur e.g. when tax receipts exceed the volume of government expenditures) and that the payment is made by a reduction of 0.9 in the cash they hold and 0.1 in their bank deposits. The payment in cash is straightforward, whereas the payment with deposits is processed by transferring 0.1 of commercial banks’ balances with the central bank to the government’s account. This leaves the non-bank sector’s money holdings with 99.9 in deposits and 14.1 in cash. For the banking sector the situation is more complicated, as the payments resulted in a reduction of required reserves to 5.4 and a reduction in deposits held to 99.9, which leaves banks (in the aggregate) with a reserve deficiency of 99.9·0.055 – 5.4 = 0.0945. If – as is typically the case – the reserve requirements are imposed on a lagged-accounting basis, which means they are predetermined by the initial level of deposits and equal 5.5, there is nothing banks can do to fulfill the requirement which would not in the same time drastically increase the interest rate (and even if a deficient bank were to sell its most liquid assets, e.g. treasury bills, then this would increase its balance but only at the expense of balances of the banks of those who buy the assets). This is astutely observed by Goodhart (1989, p. 323):
If the required reserves were to be based on a previous, known deposit base, a lagged accounting rule, then there would be nothing the banks could do by their own actions, e.g. by running down current assets, to lessen their need for reserves. Under such circumstances the authorities really have no alternative to giving them the reserves the banks require; … they can only choose the interest rate, or penalty, for providing the required reserves.
It is important to understand that net additions of liquidity by the central bank are needed only if there is an aggregate deficiency of reserves, i.e. when the banking system as a whole cannot Figure 1
Euro area money market and policy rates
Note: main policy rate; deposit and marginal lending rates – the rates on the ECB overnight deposit and lending facility, respectively; EONIA – Euro Overnight Index Average, the average overnight rate weighed with the interbank deposit market transaction volume.
Source: based on Reuters data. 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1 2 3 4 5 6
Main policy rate Deposit facility Marginal lending facility EONIA %
fulfill the reserve requirement. In turn, the fact that the amount of reserves suffices to fulfill the regulatory requirement does not imply that the reserves are adequately spread among individual banks, and in such a case individual deficiencies can be made good by individual surpluses. Since central bank’s lending and deposit facilities are available only at “penalty rates”, any bank with excess reserves can profit by lending them at a higher rate than the one offered by the central bank at its deposit facility to a bank with reserve deficiency, and the latter will gladly pay anything below what it is likely to be charged at the lending facility. Thus, the three central bank rate rates, the open-market-operations rate and the two standing facilities rates, form a corridor for the volatility of market rates. In that sense we can speak of central bank’s control over the money market rates.
Consider now another example: a client of one bank makes a payment of one unit to a client of another bank, and does so by taking a loan from his bank or utilizing a previously extended line of credit (Table 3).
Table 3
Accounting changes resulting from credit extension by individual banks
Bank A Bank B
assets liabilities assets liabilities
+1 credit +1 deposit + 1 CB balances +1 deposits
-1 CB balances – 1 deposit
The immediate effect of extending credit is growth of the balance sheet of Bank A and a corresponding growth of the money supply (by one unit). When the credit is used to make a payment to a client of Bank B, Bank A’s balance sheet declines to its initial size following a transfer of the deposit and central bank money to Bank A. The end result is an increase in the balance sheet of Bank B and no net change in the liquidity position of the banking system.
Perhaps a more interesting case is one when credit is extended in cash. Consider again the example from Table 2 and assume that the banking system makes a loan of one unit in cash to the non-bank sector. The immediate result is presented in Table 4.
Cash holdings of the non-bank public have increased by one and, naturally, so has the amount of cash in circulation on the central bank’s balance sheet. To extend the loan, the commercial bank needed to either buy physical notes and coins from the central bank by running down its balances or decrease its vault cash holdings. In either case, since the volume of deposits did not change, neither did the required reserve, and – given that in the initial equilibrium no other bank had excess reserves – the bank extending the loan must approach the central bank and request a provision of liquidity which would allow it to satisfy the reserve requirement.
The examples discussed above illustrate the single most important aspect of banking practice in stage four, namely the endogeneity of money. Unlike in the earlier periods, there is no close causal relationship between changes in the monetary base and bank deposits. High correlation between the two aggregates can be explained by the fact that they indeed tend to move together,
however now it is the change in the broader aggregates that drives the monetary base, not the other way around. We have seen that reserve requirements are calculated with reference to the previous month’s (or in any case previous period’s) liabilities, and in case of deficiencies, the authorities seeking to avoid drastic movements of short-term interest rates are left with no other choice but to supply the needed liquidity. If they overdo it, i.e. if they supply more reserves than the banking sector actually needs they will end up sterilizing excesses via the deposit facility or else putting up with rates falling virtually to zero. Thus attests Holmes (1969, p. 73), at the time Senior Vice President of the Federal Reserve Bank of New York responsible for open market operations:
The idea of a regular injection of reserves… suffers from a naïve assumption that the banking system only expands loans after the System (or market factors) have put reserves in the banking system. In the real world, banks extend credit, creating deposits in the process, and look for reserves later. The question then becomes one of whether and how the Federal Reserve will accommodate the demand for reserves. In the very short run, the Federal Reserve has little or no choice about accommodating that demand…
Moreover, to the extent that, as we have argued, monetary base consists by and large of notes and coins in the hands of the public, it is plausible that there exists not a unidirectional but bivariate causality pattern between money and nominal income. Since monetary base is determined by the demand for banknotes, and the demand for banknotes is determined by current and past consumers’ expenditures (Foot et al., 1979), then money supply growth can trigger growth of nominal income, which eventually feeds back into the growth of notes and coins in circulation.
Table 4
The economy after the extension of credit
Central bank Banking sector Non-bank private sector
assets liabilities assets liabilities assets liabilities
Banks’
balances 1.5 Balances with CB 0.5 Deposits 100.0
Vault
cash 4.0 Vault cash 4.0 Equity in banks 10.0
Cash in
circulation 16.0 Other assets 105.5 Cash 15.0
Government
deposits 5.0 Deposits 100.0 Loanin cash 1.0
Capital 10.0
The short account of banking history presented in this section was meant to give a vague idea of how the key monetary institutions have developed and how they influenced the money– supply mechanism. We have argued that for the most part of history money was, as a practical matter, exogenous, i.e. its supply was more or less anchored by the stock of gold in the economy, and remained so until the creation of central banks and the fall of the gold standard. Freed from the necessity to peg the price of gold and limit their issue of reserves accordingly, central banks have started to control the short-term interest rate by accommodating the needs for cash of the banking system at the price of their own choosing. Now, it could be asked whether the development of banking could have conceivably followed a different path – one which would keep the money supply exogenous, fixed according to the wishes of the monetary authorities. The problem is that if the central bank is supposed to be an institution which facilitates the “smooth functioning of the payment system” and performs the function of a lender of last resort, then such control is hardly imaginable. Thus, Von Hagen (1999, pp. 685-686) is worth quoting to this effect, as he provides an interesting account of monetary targeting by the Bundesbank:
… the Bank’s instruments consisted only of lending to commercial banks under automatic-access facilities (discount and Lombard credit), offering short-term paper at preset interest rates, and foreign exchange market interventions. Importa ntly, t hese inst ruments lef t t he initiative for creating cent ral money la rgely wit h t he ba n k ing system. Bundesbank Council members were often frustrated by the impression that they had much less control over central bank money growth than the banking industry. One indication of this frustration is the frequent description of the Bank as a self-service store for central bank money’ used in Council meetings in the early 1970s [emphasis added]. Goodhart (1994, p. 1425) concurs and explicitly states that even “if the central bank tried to run a system of monetary base control, it would fail”. Meulendyke (1988, p. 392), at the time Senior Economist at the Open Market Department at the New York Fed, observes that though it is t he or et ic a l ly possible to conceive of a situation in which the central bank could refuse to provide the reserves, in practice, even during the so-called Volckerian episode of 1979–82, when the Fed was most serious about controlling the supply of money, it processed instructions to pay out reserve balances even if the action put the sending bank into overdraft (idem, 1993, p. 10). In any case, it is perhaps safest to conclude these considerations by observing that though it might be possible for the central bank, by closing its lending facility, to strictly control the money supply, rendering it exogenous vis-à-vis the economic system, historically this has not been how central banks and banking systems operated.
3. Money endogeneity in Poland
In the preceding section we have analyzed the endogeneity of money from a historical perspective, tying its evolution to the historical development of banking and financial institutions. In contrast, the main focus of this section is an empirical investigation of the money supply process in Poland. We shall first present the current monetary policy implementation strategy of the National Bank